The Miracle of Compounding
Albert Einstein is often attributed with the following quote: “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t, pays it.” I don’t know if he actually did say it or not, but the moral of the story remains the same. Understanding how compound interest works is at the heart of finance. If you borrow a lot of money, someone else is going to get the benefit of compound interest. If you invest your money you have the ability to earn compound interest. The hard part to wrap our minds around is how powerful compounding actually is. That is because the way compound interest is calculated is using an exponential formula.
The actual formula is:
Now, for my nerds out there who like using formulas and algorithms to solve for an exact answer, feel free to take this baby for a spin and have some fun. What about the rest of us that just want to get an idea if we can reach our goals when we invest? I have good news, and bad news. The bad news is, I cannot eliminate math altogether. The good news is, I can show you how to do an awesome shortcut on your calculator. This is because of this nifty thing called the Rule of 72. You take whatever rate of return you think you can get on your investments, and divide that number into 72, and that will tell you about how many years it will take to double your money. For example, if you think you can earn 9 percent on your investments, every 8 years you will double your money because 72 divided by 9 equals 8.
So how is this useful? Because if you know approximately how long you have to invest, are able to approximate how long it will take to double, and can double stuff easily in your head, you can find out if you can reach your goals pretty quickly. Let’s say you are 35. You want to retire at 65. You hear someone say that stocks average 10 percent per year. You have $10,000 to invest. 72 divided by 10 is roughly 7, you have five 7-year periods in the next 35 years, and so your money will double 5 times. Here we go:
First double: $10,000 > $20,000
Second double: $20,000 > $40,000
Third Double: $40,000 > $80,000
Fourth Double: $80,000 > $160,000
Fifth Double: $160,000 > $320,000
So your next question might be, “How do I know how much interest I will earn, and what should I invest in?” Here is my absolute, no-bullshit answer: Don’t try to do those things on your own yet. There are a lot of very smart people who spend their entire lives trying to figure these things out, and frankly, still don’t have an exact answer. Find a person or a platform that can help you learn about the more complex topics as time goes on. The important part is developing the good financial habit of saving money regularly and investing into something that earns some rate of return.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
Guided Wealth Portfolios (GWP) is a centrally managed, algorithm-based, investment program sponsored by LPL Financial LLC (LPL). GWP uses proprietary, automated, computer algorithms of FutureAdvisor to generate investment recommendations based upon model portfolios constructed by LPL. FutureAdvisor and LPL are nonaffiliated entities. If you are receiving advisory services in GWP from a separately registered investment advisor firm other than LPL or FutureAdvisor, LPL and FutureAdvisor are not affiliates of such advisor. Both LPL and FutureAdvisor are investment advisors registered with the U.S. Securities and Exchange Commission, and LPL is also a Member FINRA/SIPC.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.